Central Banks Vs. Deflationary Spiral

The past two weeks were unprecedented in the size of monetary expansion around
the world. World financial authorities have finally realized that the economy
is on the edge of a deflationary spiral as in the following diagram:

The result of the spiral may well be a world economic depression.

Despite a steady progression by the central banks to zero percent interest
rates and a quantitative easing policy, the reaction of most world markets
was either muted or negative. Continually falling prices on energy, base metals
and other commodities indicate that deflationary forces prevail, at least for
now.

While there are many reasons for deflation, we will list the ones that are
most important in our opinion:

Main efforts by the Fed have, up to now, been directed toward systemic
risk. Huge increases in the Fed's balance sheet have not led to a reflationary
effect, since the Fed is still using a "sterilization" mechanism.

Most of these so-called bailout programs have been made by providing "bridge
loans" to banks and other financial institutions. These loans are not given
in cash, but rather in special short term Fed bills in exchange for collateral
(bad assets). While these funds strengthen the balance sheet, they cannot
be used to give out further loans (i.e. they are restricted for commercial
lending). Therefore, these bridge loans do not lead to new money creation
but only to toxic securities sterilization.

Despite the Fed's attempts to improve the balance sheets of the banks,
raising capital from the private sector by financial institutions remains
extremely difficult. Moreover, steep contraction in commercial credit continues,
banks are tightening lending standards and are hoarding money. As a result,
bank excess reserves with the Fed have grown from just about zero to $600
billion over the past four months.

Decrease in the velocity of money mainly due to the crisis in the financial
system and the resultant worldwide economic recession is another major
deflationary force.

Through numerous declarations from all sorts of officials, it is clear that
most of central bankers around the world are ready to use non-standard methods
of reflation - massive new money creation, direct injection of money into
the economy and debt monetization - in other words, quantitative easing.

The Fed and the Treasury have already started this. Starting September, the
US Treasury issued around $1 trillion of new debt and for the most part sent
it over to the Fed to hold. Only a small portion of this money has been spent,
but they are about to pull the trigger on the rest. Many other central banks
are starting similar programs.

Money will be spent on different types of fiscal stimuli, investing/spending
programs, tax cuts, etc. Economic effectiveness of these programs is questionable.
But as for reflation, their effectiveness does not really matter. The budget
deficit is currently about $400 billion. Based on varying estimates, by next
year it could reach $1.1 to 2.0 trillion.

A huge amount of new money creation is inevitable and the Fed's response
is an openly declared monetization of this debt.

Last week, the first stage of this process has already begun with the purchases
of debt of the Government Sponsored Enterprises (GSEs), which in turn is already
guaranteed by the US government.

Additionally, Bernanke has openly stated that the Fed stands ready to buy
long-term government bonds in order to decrease mortgage rates and the cost
of servicing US government debt. The results are evident: a bond market bubble.

Is this policy sustainable? For some time, but not for long.

The problem for the Fed is that about $5 trillion of government debt (more
than one third of the GDP) is held by foreigners. Most important US creditors
are China, Japan and the Gulf States. For these creditors to continue to
buy US debt while the interest rates are artificially deflated is not only
unprofitable but also dangerous.

Japan has already hinted that it will only make further purchases of US debt
only if such debt is denominated in yen. This means that the US trade partners
see the threat of the US dollar decline, which could start as quickly and furiously
as has been its recent rebound.

Conclusion: If the Fed continues, as declared, to support interest rates at
artificially low levels by the way of debt monetization, a major down-leg in
the US dollar is inevitable. What's most difficult is to predict is timing.
We believe that this process will occur in full swing in the first part of
the next year.

Gold and Gold Stocks

After gold touched its 200-day moving average, it quickly plunged through
several important support levels. Another touch in the area of low 700s appears
quite possible once again. It would be important for the metal, however, to
hold above its previous intraday low of $699.

The downtrend in the $HUI - Gold ratio remains in effect, which makes gold
stocks susceptible to a short term downside.

On daily charts, the index is headed, in our opinion, for another test of
170-180.

However, on a longer term basis, we see that the precious metal stocks, despite
short term volatility, are now in the early stage of a big rally. 250-260 resistance
level will be crucial.

Fundamentally, the situation in the PM sector is very similar to that of in
2000-2001. Our strategy is to maintain a good exposure to gold
and gold stocks. Buying is appropriate on weakness, while selective selling
can be done to raise cash and to rebalance into stronger, more solid performers.
More details in the RSG Newsletter.

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